# The Financing Decision

```Tools for Assessing
Dividend Policy
Aswath Damodaran
1
Assessing Dividend Policy

Approach 1: The Cash/Trust Nexus
– Assess how much cash a firm has available to pay in dividends, relative
what it returns to stockholders. Evaluate whether you can trust the
managers of the company as custodians of your cash.

Approach 2: Peer Group Analysis
– Pick a dividend policy for your company that makes it comparable to
other firms in its peer group.
2
I. The Cash/Trust Assessment



Step 1: How much could the company have paid out during the period
under question?
Step 2: How much did the the company actually pay out during the
period in question?
Step 3: How much do I trust the management of this company with
excess cash?
– How well did they make investments during the period in question?
– How well has my stock performed during the period in question?
3
A Measure of How Much a Company Could
have Afforded to Pay out: FCFE

The Free Cashflow to Equity (FCFE) is a measure of how much cash
is left in the business after non-equity claimholders (debt and preferred
stock) have been paid, and after any reinvestment needed to sustain the
firm’s assets and future growth.
Net Income
+ Depreciation &amp; Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs
- Principal Repayments
+ Proceeds from New Debt Issues
= Free Cash flow to Equity
4
Estimating FCFE when Leverage is Stable
Net Income
- (1- ) (Capital Expenditures - Depreciation)
- (1- ) Working Capital Needs
= Free Cash flow to Equity
 = Debt/Capital Ratio
For this firm,
– Proceeds from new debt issues = Principal Repayments +  (Capital
Expenditures - Depreciation + Working Capital Needs)
5
An Example: FCFE Calculation

Consider the following inputs for Microsoft in 1996. In 1996,
Microsoft’s FCFE was:
–
–
–
–
–

Net Income = \$2,176 Million
Capital Expenditures = \$494 Million
Depreciation = \$ 480 Million
Change in Non-Cash Working Capital = \$ 35 Million
Debt Ratio = 0%
FCFE = Net Income - (Cap ex - Depr) (1-DR) - Chg WC (!-DR)
= \$ 2,176
- (494 - 480) (1-0)
= \$ 2,127 Million
- \$ 35 (1-0)
6
Microsoft: Dividends?

By this estimation, Microsoft could have paid \$ 2,127 Million in
dividends/stock buybacks in 1996. They paid no dividends and bought
back no stock. Where will the \$2,127 million show up in Microsoft’s
balance sheet?
7
0
Dividends with negative FCFE
&gt;100%
95-100%
90-95%
85-90%
80-85%
75-80%
70-75%
65-70%
60-65%
55-60%
50-55%
45-50%
40-45%
35-40%
30-35%
25-30%
20-25%
15-20%
10-15%
5-10%
0 -5%
Number of firms
Dividends versus FCFE: U.S.
Figure 11.2: Dividends paid as % of FCFE
300
250
200
150
100
50
Dividends/FCFE
8
The Consequences of Failing to pay FCFE
Chrysler: FCFE, Dividends and Cash Balance
\$3,000
\$9,000
\$8,000
\$2,500
\$7,000
\$2,000
\$1,500
\$5,000
\$4,000
\$1,000
Cash Balance
Cash Flow
\$6,000
\$3,000
\$500
\$2,000
\$0
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
(\$500)
\$1,000
\$0
Year
= Free CF to Equity
= Cash to Stockholders
Cumulated Cash
9
6 Application Test: Estimating your firm’s
FCFE
In General,
Net Income
+ Depreciation &amp; Amortization
- Capital Expenditures
- Change in Non-Cash Working Capital
- Preferred Dividend
- Principal Repaid
+ New Debt Issued
= FCFE
Compare to
Dividends (Common)
If cash flow statement used
Net Income
+ Depreciation &amp; Amortization
+ Capital Expenditures
+ Changes in Non-cash WC
+ Preferred Dividend
+ Increase in LT Borrowing
+ Decrease in LT Borrowing
+ Change in ST Borrowing
= FCFE
-Common Dividend
- Decrease in Capital Stock
+ Increase in Capital Stock
10
A Practical Framework for Analyzing Dividend
Policy
How much did the firm pay out? How much could it have afforded to pay out?
What it could have paid out
What it actually paid out
Net Income
Dividends
- (Cap Ex - Depr’n) (1-DR)
+ Equity Repurchase
- Chg Working Capital (1-DR)
= FCFE
Firm pays out too little
FCFE &gt; Dividends
Firm pays out too much
FCFE &lt; Dividends
Do you trust managers in the company with
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
What investment opportunities does the
firm have?
Look at past project choice:
Compare ROE to Cost of Equity
ROC to WACC
Firm has history of
good project choice
and good projects in
the future
Firm has history
of poor project
choice
Firm has good
projects
Give managers the
flexibility to keep
cash and set
dividends
Force managers to
justify holding cash
or return cash to
stockholders
Firm should
cut dividends
and reinvest
more
Firm has poor
projects
Firm should deal
with its investment
problem first and
then cut dividends
11
A Dividend Matrix
12
More on Microsoft

As we noted earlier, Microsoft had accumulated a cash balance of \$ 43
billion by 2003 by paying out no dividends while generating huge
FCFE. At the end of 2003, there was no evidence that
– Microsoft was being penalized for holding such a large cash balance
– Stockholders were becoming restive about the cash balance. There was no
hue and cry demanding more dividends or stock buybacks.

Why?
13
Microsoft’s big dividend in 2004

In 2004, Microsoft announced a huge special dividend of \$ 5 billion
and made clear that it would try to return more cash to stockholders in
the future. What do you think changed?
14
Disney: An analysis of FCFE from 1994-2003
Year
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Net
Income
\$1,110.40
\$1,380.10
\$1,214.00
\$1,966.00
\$1,850.00
\$1,300.00
\$920.00
(\$158.00)
\$1,236.00
\$1,267.00
Depreciation
\$1,608.30
\$1,853.00
\$3,944.00
\$4,958.00
\$3,323.00
\$3,779.00
\$2,195.00
\$1,754.00
\$1,042.00
\$1,077.00
Capital
Expenditures
\$1,026.11
\$896.50
\$13,464.00
\$1,922.00
\$2,314.00
\$2,134.00
\$2,013.00
\$1,795.00
\$1,086.00
\$1,049.00
Average
\$1,208.55
\$2,553.33
\$2,769.96
Change in
non-cash
WC
\$654.10
(\$270.70 )
\$617.00
(\$174.00)
\$939.00
(\$363.00)
(\$1,184.00)
\$244.00
\$27.00
(\$264.00)
FCFE
(before
debt CF)
\$1,038.49
\$2,607.30
(\$8,923.00)
\$5,176.00
\$1,920.00
\$3,308.00
\$2,286.00
(\$443.00)
\$1,165.00
\$1,559.00
Net CF
from Debt
\$551.10
\$14.20
\$8,688.00
(\$1,641.00)
\$618.00
(\$176.00)
(\$2,118.00)
\$77.00
\$1,892.00
(\$1,145.00)
FCFE
(after
Debt CF)
\$1,589.59
\$2,621.50
(\$235.00)
\$3,535.00
\$2,538.00
\$3,132.00
\$168.00
(\$366.00)
\$3,057.00
\$414.00
\$22.54
\$969.38
\$676.03
\$1,645.41
15
Disney’s Dividends and Buybacks from 1994 to
2003
Disney
Year
Dividends (in \$)
Equity Repurchases (in
\$)
Cash to Equity
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
\$153
\$180
\$271
\$342
\$412
\$0
\$434
\$438
\$428
\$429
\$571
\$349
\$462
\$633
\$30
\$19
\$166
\$1,073
\$0
\$0
\$724
\$529
\$733
\$975
\$442
\$19
\$600
\$1,511
\$428
\$429
Average
\$ 308.70
\$ 330.30
\$ 639
16
Disney: Dividends versus FCFE

Disney paid out \$ 37 million less in dividends (and stock buybacks)
than it could afford to pay out (Dividends and stock buybacks wer
\$639 million; FCFE before net debt issues was \$676 million). How
much cash do you think Disney accumulated during the period?
17
Disney’s track record on projects and
stockholder wealth
Figure 11.3: ROE, Return on Stock and Cost of Equity: Disney
Disney acquired Cap
Cities in 1996
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
-20.00%
-30.00%
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Year
ROE
Return on Stock
Cost of Equity
18
Can you trust Disney’s management?



Given Disney’s track record over the last 10 years, if you were a
Disney stockholder, would you be comfortable with Disney’s dividend
policy?
Yes
No
19
The Bottom Line on Disney Dividends




Disney could have afforded to pay more in dividends during the period
of the analysis.
It chose not to, and used the cash for acquisitions (Capital Cities/ABC)
and ill fated expansion plans (Go.com).
While the company may have flexibility to set its dividend policy a
flexibility.
Bottom line: Large cash balances will not be tolerated in this company.
Expect to face relentless pressure to pay out more dividends.
20
Aracruz: Dividends and FCFE: 1998-2003
Year
1998
1999
2000
2001
2002
2003
Net
Income
\$3.45
\$90.77
\$201.71
\$18.11
\$111.91
\$148.09
Average
\$95.67
Change in
Capital
non-cash
Depreciation Expenditures
WC
\$152.80
\$88.31
\$76.06
\$158.83
\$56.47
\$2.18
\$167.96
\$219.37
\$12.30
\$162.57
\$421.49
(\$56.76)
\$171.50
\$260.70
(\$5.63)
\$162.57
\$421.49
(\$7.47)
\$162.70
\$244.64
\$3.45
FCFE
(before net
Debt CF)
(\$8.11)
\$190.95
\$138.00
(\$184.06)
\$28.34
(\$103.37)
Net Debt
Cashflow
\$174.27
(\$60 4.48)
(\$292.07)
\$318.24
\$36.35
\$531.20
FCFE
(after net
Debt CF)
\$166.16
(\$413.53)
(\$154.07)
\$134.19
\$64.69
\$427.83
\$10.29
\$27.25
\$37.54
21
Aracruz: Cash Returned to Stockholders
Year
1998
1999
2000
2001
2002
2003
1998 2003
Net Income Dividends Payout Ratio
\$3.45
\$90.77
\$201.71
\$18.11
\$111.91
\$148.09
\$574.04
\$24.39
\$18.20
\$57.96
\$63.17
\$73.80
\$109.31
\$346.83
707.51%
20.05%
28.74%
348.87%
65.94%
73.81%
60.42%
FCFE
\$166.16
(\$413.53)
(\$154.07)
\$134.19
\$64.69
\$427.83
\$225.27
Cash returned to
Stockholders
\$50.79
\$18.20
\$80.68
\$63.17
\$75.98
\$112.31
\$401.12
Cash Returned/FCFE
30.57%
NA
NA
47.08%
117.45%
26.25%
178.07%
22
Aracruz: Stock and Project Returns
Figure 11.4: ROE, Return on Stock and Cost of Equity: Aracruz
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
-20.00%
1998
1999
2000
ROE
2001
Return on stock
2002
2003
1998-2003
Cost of Equity
23



Assume that you are a large stockholder in Aracruz. They have been
paying more in dividends than they have available in FCFE. Their
project choice has been acceptable and your stock has performed well
over the period. Would you accept a cut in dividends?
Yes
No
24
Mandated Dividend Payouts





There are many countries where companies are mandated to pay out a
certain portion of their earnings as dividends. Given our discussion of
FCFE, what types of companies will be hurt the most by these laws?
Large companies making huge profits
Small companies losing money
High growth companies that are losing money
High growth companies that are making money
25
BP: Dividends- 1983-92
1
Net Income
2
3
4
5
6
7
8
10
\$712.00
\$947.00
\$1,256.00
\$1,626.00 \$2,309.00 \$1,098.00
\$2,076.00
- (Cap. Exp - Depr)*(1-DR) \$1,499.00
\$1,281.00 \$1,737.50 \$1,600.00
\$580.00
∂ Working Capital*(1-DR)
\$369.50
(\$286.50)
\$678.50
= Free CF to Equity
(\$612.50)
\$631.50
(\$107.00) (\$584.00) \$3,764.00
\$1,940.50 \$1,022.00
Dividends
\$831.00
\$949.00
\$1,079.00 \$1,314.00
\$1,391.00
\$1,961.00 \$1,746.00 \$1,895.00 \$2,112.00 \$1,685.00
\$831.00
\$949.00
\$1,079.00 \$1,314.00
\$1,391.00
\$1,961.00 \$1,746.00 \$1,895.00 \$2,112.00 \$1,685.00
66.16%
58.36%
\$82.00
\$2,140.00 \$2,542.00 \$2,946.00
9
\$1,184.00 \$1,090.50 \$1,975.50 \$1,545.50 \$1,100.00
(\$2,268.00) (\$984.50)
\$429.50
\$1,047.50
(\$77.00)
(\$305.00) (\$415.00)
(\$528.50)
\$262.00
+ Equity Repurchases
= Cash to Stockholders
Dividend Ratios
Payout Ratio
Cash Paid as % of FCFE
-135.67%
46.73%
119.67%
67.00%
91.64%
68.69%
64.32%
296.63%
177.93%
150.28% -1008.41% -225.00%
36.96%
101.06%
170.84% -2461.04% -399.62%
643.13%
Performance Ratios
1. Accounting Measure
ROE
9.58%
12.14%
19.82%
9.25%
12.43%
15.60%
21.47%
19.93%
4.27%
7.66%
Required rate of return
19.77%
6.99%
27.27%
16.01%
5.28%
14.72%
26.87%
-0.97%
25.86%
7.12%
Difference
-10.18%
5.16%
-7.45%
-6.76%
7.15%
0.88%
-5.39%
20.90%
-21.59%
0.54%
26
BP: Summary of Dividend Policy
Summary of calculations
Average
Standard Deviation
\$571.10
\$1,382.29
\$3,764.00
(\$612.50)
Dividends
\$1,496.30
\$448.77
\$2,112.00
\$831.00
Dividends+Repurchases
\$1,496.30
\$448.77
\$2,112.00
\$831.00
11.49%
20.90%
-21.59%
Free CF to Equity
Dividend Payout Ratio
84.77%
Cash Paid as % of FCFE
262.00%
ROE - Required return
-1.67%
Maximum Minimum
27
BP: Just Desserts!
28
The Limited: Summary of Dividend Policy:
1983-1992
Summary of calculations
Average
Standard Deviation
Maximum Minimum
Free CF to Equity
(\$34.20)
\$109.74
\$96.89
(\$242.17)
Dividends
\$40.87
\$32.79
\$101.36
\$5.97
Dividends+Repurchases
\$40.87
\$32.79
\$101.36
\$5.97
Dividend Payout Ratio
18.59%
19.07%
29.26%
-19.84%
Cash Paid as % of FCFE -119.52%
ROE - Required return
1.69%
29
Growth Firms and Dividends
High growth firms are sometimes advised to initiate dividends because
its increases the potential stockholder base for the company (since
there are some investors - like pension funds - that cannot buy stocks
that do not pay dividends) and, by extension, the stock price. Do you
agree with this argument?
 Yes
 No
Why?

30
Summing up…
31
6 Application Test: Assessing your firm’s
dividend policy

Compare your firm’s dividends to its FCFE, looking at the last 5 years
of information.

you encourage the firm to return more cash or less cash to its owners?

If you would encourage it to return more cash, what form should it
32
II. The Peer Group Approach - Disney
Company Name
Astral Media Inc. 'A'
Belo Corp. 'A'
CanWest Global Comm. Corp.
Cinram Intl Inc
Clear Channel
Cumu lus Media Inc
Disney (Walt)
Emm is Communications
Entercom Co mm. Corp
Fox Entmt Group Inc
Hearst -Argyle Television Inc
InterActiveCorp
Liberty Media 'A'
Lin TV Corp.
Metro Goldwyn Mayer
Pixar
Rega l Entertainment Group
Sirius Satellite
Time Warner
Divid en d Yield
Divid en d Payo u t
0.00%
1.34%
0.00%
0.00%
0.85%
0.00%
0.00%
0.90%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
2.70%
0.00%
0.00%
0.00%
0.00%
34.13%
0.00%
0.00%
35.29%
0.00%
0.00%
32.31%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
66.57%
0.00%
0.00%
0.00%
Univision Comm unic.
Viacom Inc. 'B'
Westwood One
XM Satellit e `A'
0.00%
0.56%
0.00%
0.00%
0.00%
19.00%
0.00%
0.00%
Average
0.24%
7.20%
33
Peer Group Approach: Deutsche Bank
Name
Banca Intesa Spa
Banco Bilbao Vizcaya Argenta
Banco Santander C entral Hisp
Barc lays Plc
Bnp Par ibas
Deuts che Bank Ag -Reg
Erste Ban k Der Oester Spark
Hbos Plc
Hsbc Holdings Plc
Lloyds Tsb Group Plc
Roya l Bank Of Scotland Group
Sanpaolo Imi Spa
Societe Generale
Standard Chartered P lc
Unicredito Italiano Spa
Average
Dividend Yield
1.57%
0.00%
0.00%
3.38%
0.00%
1.98%
0.99%
2.85%
2.51%
7.18%
3.74%
0.00%
0.00%
3.61%
0.00%
1.85%
Dividend Payout
167.50%
0.00%
0.00%
35.61%
0.00%
481.48%
24.31%
27.28%
39.94%
72.69%
38.73%
0.00%
0.00%
46.35%
0.00%
62.26%
34
Peer Group Approach: Aracruz
Group
Latin Amer ica
Emerging
Market
US
All p a per and
pu lp
Aracruz
Dividend
Yield
2.86%
Dividend
Payout
41.34%
2.03%
1.14%
22.16%
28.82%
1.75%
3.00%
34.55%
37.41%
35
A High Growth Bank?

Assume that you are advising a small high-growth bank, which is
concerned about the fact that its dividend payout and yield are much
lower than other banks. The CEO of the bank is concerned that
investors will punish the bank for its dividend policy. What do you
think?
a. I think that the bank will be punished for its errant dividend policy
b. I think that investors are sophisticated enough for the bank to be treated
fairly
c. I think that the bank will not be punished for its low dividends as long as it
tries to convey information to its investors about the quality of its projects
and growth prospects.
36
Going beyond averages… Looking at the
market

Regressing dividend yield and payout against expected growth yields:
PYT = 0.3889 - 0.738 CPXFR - 0.214 INS + 0.193 DFR - 0.747 EGR
(20.41)
(3.42)
(3.41) (4.80) (8.12)
R2 =
18.30%
YLD = 0.0205 - 0.058 CPXFR - 0.012 INS + 0.0200 DFR - 0.047 EGR
(22.78)
(5.87)
(3.66)
(9.45)
(11.53)
R2 =
28.5%
– PYT = Dividend Payout Ratio = Dividends/Net Income
– YLD = Dividend Yield = Dividends/Current Price
– CPXFR = Capital Expenditures / Book Value of Total Assets
– EGR = Expected growth rate in earnings over next 5 years (analyst
estimates)
– DFR = Debt / (Debt + Market Value of Equity)
– INS = Insider holdings as a percent of outstanding stock
37
Disney and Aracruz ADR vs US Market

For Disney
– Payout Ratio = 0.3889 - 0.738 (0.021)- 0.214 (0.026) + 0.193 (0.2102) 0.747 (0.08) = 34.87%
– Dividend Yield = 0.0205 - 0.058 (0.021)- 0.012 (0.026) + 0.0200
(0.2102)- 0.047 (0.08)= 1.94%
Disney is paying out too little in dividends, with its payout ratio of 32.31%
and its dividend yield of 0.91%

– Payout Ratio = 0.3889 - 0.738 (0.02)- 0.214 (0.20) + 0.193 (0.31) - 0.747
(0.23) = 21.71%
– Dividend Yield = 0.0205 - 0.058 (0.02)- 0.012 (0.20)+ 0.0200 (0.31)0.047 (0.23) = 1.22%
Aracruz is paying out too much in dividends, with its payout ratio of 37.41%
and its dividend yield of 3%
38
Other Actions that affect Stock Prices


In the case of dividends and stock buybacks, firms change the value of
the assets (by paying out cash) and the number of shares (in the case of
There are other actions that firms can take to change the value of their
stockholder’s equity.
– Divestitures: They can sell assets to another firm that can utilize them
more efficiently, and claim a portion of the value.
– Spin offs: In a spin off, a division of a firm is made an independent entity.
The parent company has to give up control of the firm.
– Equity carve outs: In an ECO, the division is made a semi-independent
entity. The parent company retains a controlling interest in the firm.
– Tracking Stock: When tracking stock are issued against a division, the
parent company retains complete control of the division. It does not have
its own board of directors.
39
Differences in these actions
40
Valuation
Aswath Damodaran
41
First Principles

Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
– The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money (debt)
– Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.


Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
– The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
Objective: Maximize the Value of the Firm
42
Discounted Cashflow Valuation: Basis for
Approach
t = n CF
t
Value = 
t
t =1 (1 + r)
– where,
– n = Life of the asset
– CFt = Cashflow in period t
– r = Discount rate reflecting the riskiness of the estimated cashflows
43
Equity Valuation

The value of equity is obtained by discounting expected cashflows to
equity, i.e., the residual cashflows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of equity,
i.e., the rate of return required by equity investors in the firm.
Value of Equity =
t=n CF

t=1
to Equity t
(1+ k e )t
where,
CF to Equityt = Expected Cashflow to Equity in period t
ke = Cost of Equity

The dividend discount model is a specialized case of equity valuation,
and the value of a stock is the present value of expected future
dividends.
44
Firm Valuation

The value of the firm is obtained by discounting expected cashflows to
the firm, i.e., the residual cashflows after meeting all operating
expenses and taxes, but prior to debt payments, at the weighted
average cost of capital, which is the cost of the different components of
financing used by the firm, weighted by their market value
proportions.
Value of Firm =
t=n
CF to Firm t
 (1+ WACC)t
t=1
where,
CF to Firmt = Expected Cashflow to Firm in period t
WACC = Weighted Average Cost of Capital
45
Generic DCF Valuation Model
DISCOUNTED CASHFLOW VALUATION
Expected Growth
Firm: Growth in
Operating Earnings
Equity: Growth in
Net Income/EPS
Cash flows
Firm: Pre-debt cash
flow
Equity: After debt
cash flows
Firm is in stable growth:
Grows at constant rate
forever
Terminal Value
Value
Firm: Value of Firm
CF1
CF2
CF3
CF4
CF5
CFn
.........
Forever
Equity: Value of Equity
Length of Period of High Growth
Discount Rate
Firm:Cost of Capital
Equity: Cost of Equity
46
Estimating Inputs:
I. Discount Rates



Critical ingredient in discounted cashflow valuation. Errors in
estimating the discount rate or mismatching cashflows and discount
rates can lead to serious errors in valuation.
At an intuitive level, the discount rate used should be consistent with
both the riskiness and the type of cashflow being discounted.
The cost of equity is the rate at which we discount cash flows to equity
(dividends or free cash flows to equity). The cost of capital is the rate
at which we discount free cash flows to the firm.
47
Estimating Aracruz’s Cost of Equity


We will do the Aracruz valuation in U.S. dollars. We will therefore use
a U.S. dollar cost of equity.
We estimated a beta for equity of 0.7576 for the paper business that
Aracruz. With a nominal U.S. dollar riskfree rate of 4% and an equity
risk premium of 12.49% for Brazil, we arrive at a dollar cost of equity
of 13.46%
Cost of equity = 4% + 0.7576 (12.49%) = 13.46%
48
Estimating Cost of Equity: Deutsche Bank

Deutsche Bank is in two different segments of business - commercial
banking and investment banking.
– To estimate its commercial banking beta, we will use the average beta of
commercial banks in Germany.
– To estimate the investment banking beta, we will use the average bet of
investment banks in the U.S and U.K.
To estimate the cost of equity in Euros, we will use the German 10year bond rate of 4.05% as the riskfree rate and the US historical risk
Beta
Cost of Equity Weights
Commercial Banking
0.7345
7.59%
69.03%
Investment Banking
1.5167
11.36%
30.97%
Deutsche Bank
8.76%

49
Reviewing Disney’s Costs of Equity &amp; Debt
Medi a Networks
Parks an d
Resorts
Studio
Entertainment
Consumer
Products
Disn e y


D/E
Unlevered Beta Ratio
1.08 5 0
26.6 2 %
Lever e d
Beta
1.26 6 1
Cost of
Equit y
10.1 0 %
0.91 0 5
26.6 2 %
1.06 2 5
9.12%
1.14 3 5
26.6 2 %
1.33 4 4
10.4 3 %
1.13 5 3
1.06 7 4
26.6 2 %
26.6 2 %
1.32 4 8
1.24 5 6
10.3 9 %
10.0 0 %
Disney’s Cost of Debt (based upon rating) = 5.25%
Disney’s tax rate = 37.3%
50
Current Cost of Capital: Disney

Equity
– Cost of Equity = Riskfree rate + Beta * Risk Premium
= 4% + 1.25 (4.82%) = 10.00%
– Market Value of Equity =
\$55.101 Billion
– Equity/(Debt+Equity ) =
79%

Debt
– After-tax Cost of debt =(Riskfree rate + Default Spread) (1-t)
= (4%+1.25%) (1-.373) = 3.29%
– Market Value of Debt =
\$ 14.668 Billion
– Debt/(Debt +Equity) =
21%

Cost of Capital = 10.00%(.79)+3.29%(.21) = 8.59%
55.101(55.101+14.
668)
51
II. Estimating Cash Flows
Cash Flows
To Equity
The Strict View
Dividends +
To Firm
Net Income
- Net Cap Ex (1-Debt Ratio)
- Chg WC (1 - Debt Ratio)
= Free Cashflow to Equity
EBIT (1-t)
- ( Cap Ex - Depreciation)
- Change in Working Capital
= Free Cashflow to Firm
52
Estimating FCFE last year: Aracruz
2003 numbers
Normalized
Net Income from operating assets \$119.68 million \$ 119.68 million
- Net Capital Expenditures (1-DR) \$ 37.31 million \$ 71.45 million
-Chg. Working Capital*(1-DR)
\$ 3.05 million \$ 7.50 million
Free Cashflow to Equity
\$ 79.32 million \$ 40.73 million
DR = Debt Ratio = Industry average book debt to capital ratio = 55.98%
Equity Reinvestment = 71.45 million + 7.50 = \$ 78.95 million
Equity Reinvestment Rate = 78.95/ 119.68 = 65.97%
53
Estimating FCFF in 2003: Disney





EBIT = \$ 2,805 Million
Tax rate = 37.30%
Capital spending = \$ 1,735 Million
Depreciation = \$ 1,254 Million
Increase in Non-cash Working capital = \$ 454 Million
Estimating FCFF
EBIT * (1 - tax rate)
- Net Capital Expenditures
-Change in Working Capital
Free Cashflow to Firm


\$1,759
\$481
\$454
\$824
: 2805 (1-.373)
: (1735 - 1254)
Total Reinvestment = Net Cap Ex + Change in WC = 481 + 454 = 935
Reinvestment Rate =935/1759 = 53.18%
54
6 Application Test: Estimating your firm’s
FCFF
Estimate the FCFF for your firm in its most recent financial year:
In general,
If using statement of cash flows
EBIT (1-t)
EBIT (1-t)
+ Depreciation
+ Depreciation
- Capital Expenditures
+ Capital Expenditures
- Change in Non-cash WC
+ Change in Non-cash WC
= FCFF
= FCFF
Estimate the dollar reinvestment at your firm:
Reinvestment = EBIT (1-t) - FCFF

55
Choosing a Cash Flow to Discount



When you cannot estimate the free cash fllows to equity or the firm,
the only cash flow that you can discount is dividends. For financial
service firms, it is difficult to estimate free cash flows. For Deutsche
Bank, we will be discounting dividends.
If a firm’s debt ratio is not expected to change over time, the free cash
flows to equity can be discounted to yield the value of equity. For
Aracruz, we will discount free cash flows to equity.
If a firm’s debt ratio might change over time, free cash flows to equity
become cumbersome to estimate. Here, we would discount free cash
flows to the firm. For Disney, we will discount the free cash flow to
the firm.
56
III. Expected Growth
Expected Growth
Net Income
Retention Ratio=
1 - Dividends/Net
Income
X
Return on Equity
Net Income/Book Value of
Equity
Operating Income
Reinvestment
Rate = (Net Cap
Ex + Chg in
WC/EBIT(1-t)
X
Return on Capital =
EBIT(1-t)/Book Value of
Capital
57
Expected Growth in EPS
gEPS = Retained Earningst-1/ NIt-1 * ROE
= Retention Ratio * ROE
= b * ROE
• Proposition 1: The expected growth rate in earnings for a
company cannot exceed its return on equity in the long
term.
58
Estimating Expected Growth in EPS: Deutsche
Bank

In 2003, Deutsche Bank reported net income of \$1,365 million on a book
value of equity of \$29,991 million at the end of 2002.
– Return on Equity = Net Income2003/ Book Value of Equity2002 = 1365/29,991 =
4.55%

This is lower than the cost of equity for the firm, which is 8.76%, and the
average return on equity for European banks, which is 11.26%. In the four
quarters ended in March 2004, Deutsche Bank paid out dividends per share of
1.50 Euros on earnings per share of 4.33 Euros.
– Retention Ratio = 1 – Dividends per share/ Earnings per share = 1 – 1.50/4.33 =
65.36%

If Deutsche maintains its existing return on equity and retention ratio for the
long term, its expected growth rate will be anemic.
– Expected Growth Rate = Retention Ratio * ROE = .6536*.0455 = 2.97%

For the next five years, we will assume that the return on equity will improve
to the industry average of 11.26% while the retention ratio will stay unchanged
at 65.36%. The expected growth in earnings per share is 7.36%.
– Expected Growth Rate Modified Fundamentals = .6536 * .1126 = .0736
59
Estimating Expected Growth in Net Income:
Aracruz

Rather than base the equity reinvestment rate on the most recent year’s
numbers, we will use the average values for each of the variables over the last
6 years to compute a “normalized” equity reinvestment rate:
– Normalized Equity Reinvestment Rate = Average Equity Reinvestment99-03/
Average Net Income99-03 = 213.17/323.12 = 65.97%

To estimate the return on equity, we look at only the portion of the net income
that comes from operations (ignoring the income from cash and marketable
securities) and divide by the book value of equity net of cash and marketable
securities.
– Non-cash ROE = (Net Income – After-tax Interest income on cash)2003/ (BV of
Equity – Cash)2002
– Non-cash ROEAracruz = (148.09 – 43.04(1-.34))/ (1760.58-273.93) = .0805 or 8.05%

Expected Growth in Net Income = Equity Reinvestment Rate * Non-cash ROE
= 65.97% * 8.05% = 5.31%
60
ROE and Leverage
ROE = ROC + D/E (ROC - i (1-t))
where,
ROC = (EBIT (1 - tax rate)) / Book Value of Capital
= EBIT (1- t) / Book Value of Capital
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / Book Value of Debt
t = Tax rate on ordinary income
 Note that BV of Capital = BV of Debt + BV of Equity.

61
Decomposing ROE

Assume that you are analyzing a company with a 15% return on
capital, an after-tax cost of debt of 5% and a book debt to capital ratio
of 100%. Estimate the ROE for this company.

Now assume that another company in the same sector has the same
ROE as the company that you have just analyzed but no debt. Will
these two firms have the same growth rates in earnings per share if
they have the same dividend payout ratio?

Will they have the same equity value?
62
Expected Growth in EBIT And Fundamentals



Reinvestment Rate and Return on Capital
gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
Proposition 2: No firm can expect its operating income to grow over
time without reinvesting some of the operating income in net capital
expenditures and/or working capital.
Proposition 3: The net capital expenditure needs of a firm, for a given
growth rate, should be inversely proportional to the quality of its
investments.
63
Estimating Growth in EBIT: Disney

We begin by estimating the reinvestment rate and return on capital for
Disney in 2003, using the numbers from the latest financial statements.
We did convert operating leases into debt and adjusted the operating
income and capital expenditure accordingly.
– Reinvestment Rate2003 = (Cap Ex – Depreciation + Chg in non-cash WC)/
EBIT (1-t) = (1735 – 1253 + 454)/(2805(1-.373)) = 53.18%
– Return on capital2003 = EBIT (1-t)2003/ (BV of Debt2002 + BV of
Equity2002) = 2805 (1-.373)/ (15,883+23,879) = 4.42%
– Expected Growth Rate from existing fundamentals = 53.18% * 4.42% =
2.35%

We will assume that Disney will be able to earn a return on capital of
12% on its new investments and that the reinvestment rate will be
53.18% for the immediate future.
– Expected Growth Rate in operating income = Return on capital *
Reinvestment Rate = 12% * .5318 = 6.38%
64
6 Application Test: Estimating Expected
Growth

Estimate the following:
– The reinvestment rate for your firm
– The after-tax return on capital
– The expected growth in operating income, based upon these inputs
65
IV. Getting Closure in Valuation

A publicly traded firm potentially has an infinite life. The value is
therefore the present value of cash flows forever.
Value =

t =  CF
t

t
t = 1 (1+ r)
Since we cannot estimate cash flows forever, we estimate cash flows
for a “growth period” and then estimate a terminal value, to capture the
value at the end of the period:
t = N CFt
Terminal Value
Value = 

t
(1 + r)N
t = 1 (1 + r)
66
Stable Growth and Terminal Value

When a firm’s cash flows grow at a “constant” rate forever, the present
value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate



This “constant” growth rate is called a stable growth rate and cannot be
higher than the growth rate of the economy in which the firm operates.
While companies can maintain high growth rates for extended periods,
they will all approach “stable growth” at some point in time.
When they do approach stable growth, the valuation formula above can
be used to estimate the “terminal value” of all cash flows beyond.
67
Growth Patterns

A key assumption in all discounted cash flow models is the period of
high growth, and the pattern of growth during that period. In general,
we can make one of three assumptions:
– there is no high growth, in which case the firm is already in stable growth
– there will be high growth for a period, at the end of which the growth rate
will drop to the stable growth rate (2-stage)
– there will be high growth for a period, at the end of which the growth rate
will decline gradually to a stable growth rate(3-stage)

The assumption of how long high growth will continue will depend
upon several factors including:
– the size of the firm (larger firm -&gt; shorter high growth periods)
– current growth rate (if high -&gt; longer high growth period)
– barriers to entry and differential advantages (if high -&gt; longer growth
period)
68
Length of High Growth Period




Assume that you are analyzing two firms, both of which are enjoying
high growth. The first firm is Earthlink Network, an internet service
provider, which operates in an environment with few barriers to entry
and extraordinary competition. The second firm is Biogen, a biotechnology firm which is enjoying growth from two drugs to which it
owns patents for the next decade. Assuming that both firms are well
managed, which of the two firms would you expect to have a longer
high growth period?
Biogen
Both are well managed and should have the same high growth period
69
Choosing a Growth Period: Examples
Firm Size/Market Size
Current Ex cess Returns
Length of High Gro wth period
Disney
Aracruz
Deutsche Bank
Firm is one of the largest players in the
entertainment and theme park
redefining themselves and expanding.
Firm is earning less than its cost of
capital, and has done so for last fe
w
years
Has some of the mo st recognized brand
names in the world. Knows more about
operating theme parks than any other
firm in the world. Has skilled animation
studio staff.
10 years, entirely because of its strong
been wasted over the last few years) but
the excess returns are likely to be small.
Firm has a small market share of the
mature.
Firm has a significant mark et share of a
Returns on capital are largely a function
of paper/pulp pric es but, on averag e,
have been less than the cost of capital.
Brazilian rainforests. Has invested in
newer, updated plants and has skilled
workforce.
Firm has a return on equity that has
lagged its cost of equity in recent years.
raw material.
5 years, mo stly to allow fir ms to recover
to pre-downturn levels.
Has an edge in the commercial banking
is dissipating in the EU.
70
Firm Characteristics as Growth Changes
Variable
Risk
Dividend Payout
Net Cap Ex
Return on Capital
Leverage
High Growth Firms tend to
be above-average risk
pay little or no dividends
have high net cap ex
earn high ROC (excess return)
have little or no debt
Stable Growth Firms tend to
be average risk
pay high dividends
have low net cap ex
earn ROC closer to WACC
higher leverage
71
Estimating Stable Growth Inputs

– Profitability measures such as return on equity and capital, in stable
growth, can be estimated by looking at


industry averages for these measure, in which case we assume that this firm in
stable growth will look like the average firm in the industry
cost of equity and capital, in which case we assume that the firm will stop
earning excess returns on its projects as a result of competition.
– Leverage is a tougher call. While industry averages can be used here as
well, it depends upon how entrenched current management is and whether
they are stubborn about their policy on leverage (If they are, use current
leverage; if they are not; use industry averages)

Use the relationship between growth and fundamentals to estimate
payout and net capital expenditures.
72
Estimating Stable Period Inputs: Disney

The beta for the stock will drop to one, reflecting Disney’s status as a mature
company. This will lower the cost of equity for the firm to 8.82%.
Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4% + 4.82% = 8.82%


The debt ratio for Disney will rise to 30%. This is the optimal we computed for
Disney in chapter 8 and we are assuming that investor pressure will be the
impetus for this change. Since we assume that the cost of debt remains
unchanged at 5.25%, this will result in a cost of capital of 7.16%
Cost of capital = 8.82% (.70) + 5.25% (1-.373) (.30) = 7.16%
The return on capital for Disney will drop from its high growth period level of
12% to a stable growth return of 10%. This is still higher than the cost of
capital of 7.16% but the competitive advantages that Disney has are unlikely to
dissipate completely by the end of the 10th year. The expected growth rate in
stable growth will be 4%. In conjunction with the return on capital of 10%,
this yields a stable period reinvestment rate of 40%:
Reinvestment Rate = Growth Rate / Return on Capital = 4% /10% = 40%
73
A Dividend Discount Model Valuation:
Deutsche Bank



We estimated the annual growth rate for the next 5 years at Deutsche
Bank to be 7.36%, based upon an estimated ROE of 11.26% and a
retention ratio of 65.36%.
In 2003, the earnings per share at Deutsche Bank were 4.33 Euros, and
the dividend per share was 1.50 Euros.
Our earlier analysis of the risk at Deutsche Bank provided us with an
estimate of beta of 0.98, which used in conjunction with the Euro
riskfree rate of 4.05% and a risk premium of 4.82%, yielded a cost of
equity of 8.76%
74
Expected Dividends and Terminal Value
Year
EPS
Pa yo u t Ra tio
DPS
1
€ 4 .6 5
3 4 .6 4 %
€ 1 .6 1
2
€ 4 .9 9
3 4 .6 4 %
€ 1 .7 3
3
€ 5 .3 6
3 4 .6 4 %
€ 1 .8 6
4
€ 5 .7 5
3 4 .6 4 %
€ 1 .9 9
5
€ 6 .1 8
3 4 .6 4 %
€ 2 .1 4
Pre s e n t value of expe c ted d ividends =
PV at 8.
€ 1 .4
€ 1 .4
€ 1 .4
€ 1 .4
€ 1 .4
€ 7 .2
76 %
8
6
4
2
1
2
75
Terminal Value and Present Value…

At the end of year 5, we will assume that Deutsche Bank’s earnings growth
will drop to 4% and stay at that level in perpetuity. In keeping with the
assumption of stable growth, we will also assume that
– The beta will rise marginally to 1, resulting in a slightly higher cost of equity of
8.87%.
Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4.05%+ 4.82% = 8.87%
– The return on equity will drop to the cost of equity of 8.87%, thus preventing
excess returns from being earned in perpetuity.
Stable Period Payout Ratio = 1 – g/ ROE = 1- .04/.0887 = .5490 or 54.9%
Expected Dividends in year 6 = Expected EPS6 * Stable period payout ratio
=€6.18 (1.04) * .549 = €3.5263
– Terminal Value per share = Expected Dividends in year 6/ (Cost of equity – g)
= €3.5263/(.0887 - .04) = €72.41
– Present value of terminal value = 72.41/1.08765 = 47.59


Value per share = PV of expected dividends in high growth + PV of terminal
value = €7.22 + €47.59 = €54.80
Deutsche Bank was trading at €66 at the time of this analysis.
76
What does the valuation tell us?



Stock is overvalued: This valuation would suggest that Deutsche Bank
is significantly overvalued, given our estimates of expected growth and
risk.
Dividends may not reflect the cash flows generated by Deutsche Bank.
The FCFE could have been significantly higher than the dividends
paid.
Estimates of growth and risk are wrong: It is also possible that we have
underestimated growth or overestimated risk in the model, thus
reducing our estimate of value.
77
A FCFE Valuation: Aracruz Celulose

The net income for the firm in 2003 was \$148.09 million but \$28.41 million of
this income represented income from financial assets. The net income from
non-operating assets is \$119.68 million.

Inputs estimated for high growth period
–
Expected Growth in Net Income = Equity Reinvestment Rate * Non-cash ROE
= 65.97% * 8.05% = 5.31%
– Cost of equity = 4% + 0.7576 (12.49%) = 13.46%

After year 5, we will assume that the beta will remain at 0.7576 and that the
equity risk premium will decline to 8.66%.
– Cost of equity in stable growth = 4% + 0.7576 (8.66%) = 10.56%
– We will also assume that the growth in net income will drop to the inflation rate (in
U.S. dollar terms) of 2% and that the return on equity will rise to 10.56% (which is
also the cost of equity).
– Equity Reinvestment RateStable Growth = Expected Growth Rate/ Return on Equity
= 2%/10.56% = 18.94%
78
Aracruz: Estimating FCFE for next 5 years
Net Income (non-cash)
Equity Reinvestment Rate
FCFE
Present Value at 10.33%
1
\$126.04
65.97%
\$42.89
\$37.80
2
\$132.74
65.97%
\$45.17
\$35.09
3
\$139.79
65.97%
\$47.57
\$32.56
4
\$147.21
65.97%
\$50.09
\$30.23
5
\$155.03
65.97%
\$52.75
\$28.05
– FCFE in year 6 = Net Income in year 6 (1- Equity Reinvestment RateStable Growth) =
155.03 (1.02) (1- .1894) = \$128.18 million
– Terminal value of equity = 128.18/(.1056-.02) = \$1497.98 million
Present Value of FCFEs in high growth phase =
+ Present Value of Terminal Equity Value = 1497.98/1.13465 =
Value of equity in operating assets =
+ Value of Cash and Marketable Securities =
Value of equity in firm =
Value of equity/share =
\$1,312.56/859.59
=
Value of equity/share in BR = \$1.53 * 3.15 BR/\$
=
Stock price
\$163.73
\$796.55
\$960.28
\$352.28
\$1,312.56
\$1.53/share
4.81 BR/share
7.50 BR/share
79
Disney Valuation

Model Used:
– Cash Flow: FCFF (since I think leverage will change over time)
– Growth Pattern: 3-stage Model (even though growth in operating income
is only 10%, there are substantial barriers to entry)
80
Disney: Inputs to Valuation
High Growth Phase
Transition Phase
5 years
5 years
Length o f Period
Tax Rate
37.3%
Return on Capital
12% (last year’s return o
Stable Growth Phase
Forever afte r 10 years
37.3%
37.3%
n Declines linearly to 16%
Stable ROC of 10%
capital was 4.42%)
Reinve stment Rate
53.18%
(Last
year’s
Declines to 31.25% as
ROC 40%
of afte r-tax
operatin g
(Net Cap Ex + Working Capita l reinvestment rate)
and growth rates drop:
income, estimated from stabl
Investments/EBIT)
Reinvestment Rate = g/ROC
growth rate of 4% and
e
return
on capital o f 10%.
Reinvestment rate = 4/10 =40%
Expected Growth Rate i n EBIT
ROC * Reinvestment Rate
= Linear
decline t
o
Stable 4%: Set to riskfree rate
12%*0.5318 = 6.38%
Growth Rate of 4%
Debt/Capital Ratio
21% (Existing debt ratio)
Increases line arly to 30%
Stable debt rati o of 30%
Risk Parameters
Beta = 1.25, ke = 10%
Beta decreases linearly to 1.00;
Beta = 1.00; k e = 8.82%
Cost of Debt = 5.25%
Cost of debt stays at 5.25%
Cost of debt stays at 5.25%
Cost of capital = 8.59%
Cost of capital drops t o 7.16%
Cost of capital = 7.16%
81
Disney: FCFF Estimates
Year
Cur re nt
1
2
3
4
5
6
7
8
9
10
Ex p e c t e d
Gro w th
6 .3 8 %
6 .3 8 %
6 .3 8 %
6 .3 8 %
6 .3 8 %
5 .9 0 %
5 .4 3 %
4 .9 5 %
4 .4 8 %
4 .0 0 %
EBIT
\$ 2 ,80
\$ 2 ,98
\$ 3 ,17
\$ 3 ,37
\$ 3 ,59
\$ 3 ,82
\$ 4 ,04
\$ 4 ,26
\$ 4 ,47
\$ 4 ,67
\$ 4 ,86
EBIT (1t)
5
4
4
7
2
2
7
7
8
9
6
\$ 1 ,87
\$ 1 ,99
\$ 2 ,11
\$ 2 ,25
\$ 2 ,39
\$ 2 ,53
\$ 2 ,67
\$ 2 ,80
\$ 2 ,93
\$ 3 ,05
1
0
7
2
6
8
5
8
4
1
Reinv e s tm e n t
Rat e
Reinv e s tm e n t
5 3 .1 8 %
5 3 .1 8 %
5 3 .1 8 %
5 3 .1 8 %
5 3 .1 8 %
5 0 .5 4 %
4 7 .9 1 %
4 5 .2 7 %
4 2 .6 4 %
4 0 .0 0 %
\$ 9 9 4.92
\$ 1 ,05 8 .4 1
\$ 1 ,12 5 .9 4
\$ 1 ,19 7 .7 9
\$ 1 ,27 4 .2 3
\$ 1 ,28 2 .5 9
\$ 1 ,28 1 .7 1
\$ 1 ,27 1 .1 9
\$ 1 ,25 0 .7 8
\$ 1 ,22 0 .4 1
FCFF
\$ 8 7 6.06
\$ 9 3 1.96
\$ 9 9 1.43
\$ 1 ,05 4 .7 0
\$ 1 ,12 2 .0 0
\$ 1 ,25 5 .1 3
\$ 1 ,39 3 .7 7
\$ 1 ,53 6 .8 0
\$ 1 ,68 2 .9 0
\$ 1 ,83 0 .6 2
82
Disney: Costs of Capital and Present Value
Year
Co st of c ap ital
FCFF
1
8 .5 9 %
\$ 8 7 6.06
2
8 .5 9 %
\$ 9 3 1.96
3
8 .5 9 %
\$ 9 9 1.43
4
8 .5 9 %
\$ 1 ,05 4 .7 0
5
8 .5 9 %
\$ 1 ,12 2 .0 0
6
8 .3 1 %
\$ 1 ,25 5 .1 3
7
8 .0 2 %
\$ 1 ,39 3 .7 7
8
7 .7 3 %
\$ 1 ,53 6 .8 0
9
7 .4 5 %
\$ 1 ,68 2 .9 0
10
7 .1 6 %
\$ 1 ,83 0 .6 2
PV of cashflows du rin g hig h g ro wth =
PV of FCFF
\$ 8 0 6.74
\$ 7 9 0.31
\$ 7 7 4.21
\$ 7 5 8.45
\$ 7 4 3.00
\$ 7 6 7.42
\$ 7 8 8.91
\$ 8 0 7.42
\$ 8 2 2.90
\$ 8 3 5.31
\$ 7 ,89 4 .6 6
83
Disney: Terminal Value and Firm Value

Terminal Value
– FCFF11 = EBIT11 (1-t) (1- Reinvestment RateStable Growth)/
= 4866 (1.04) (1-.40) = \$1,903.84 million
– Terminal Value = FCFF11/ (Cost of capitalStable Growth – g)
= 1903.84/ (.0716 - .04) = \$60,219.11 million

Value of firm
PV of cashflows during the high growth phase
=\$ 7,894.66
PV of terminal value
=\$ 27,477.81
+ Cash and Marketable Securities
=\$ 1,583.00
+ Non-operating Assets (Holdings in other companies) =\$ 1,849.00
Value of the firm
=\$ 38,804.48
84
From Firm to Equity Value: What do you
subtract out?


The first thing you have to subtract out is the debt that you computed (and
used in estimating the cost of capital). If you have capitalized operating leases,
you should continue to treat operating leases as debt in this stage in the
process.
This is also your last chance to consider other potential liabilities that may be
faced by the firm including
– Expected liabilities on lawsuits: You could be analyzing a firm that is the defendant
in a lawsuit, where it potentially could have to pay tens of millions of dollars in
damages. You should estimate the probability that this will occur and use this
probability to estimate the expected liability.
– Unfunded Pension and Health Care Obligations: If a firm has significantly under
funded a pension or a health plan, it will need to set aside cash in future years to
meet these obligations. While it would not be considered debt for cost of capital
purposes, it should be subtracted from firm value to arrive at equity value.
– Deferred Tax Liability: The deferred tax liability that shows up on the financial
statements of many firms reflects the fact that firms often use strategies that reduce
their taxes in the current year while increasing their taxes in the future years.
85
From Equity Value to Equity Value per share:
The Effect of Options


When there are warrants and employee options outstanding, the
estimated value of these options has to be subtracted from the value of
the equity, before we divide by the number of shares outstanding.
There are two alternative approaches that are used in practice:
– One is to divide the value of equity by the fully diluted number of shares
outstanding rather than by the actual number. This approach will
underestimate the value of the equity, because it fails to consider the cash
proceeds from option exercise.
– The other shortcut, which is called the treasury stock approach, adds the
expected proceeds from the exercise of the options (exercise price
multiplied by the number of options outstanding) to the numerator before
dividing by the number of shares outstanding. While this approach will
yield a more reasonable estimate than the first one, it does not include the
time value of the options outstanding.
86
Valuing Disney’s options…




At the end of 2003, Disney had 219 million options outstanding, with a
weighted average exercise price of \$26.44 and weighted average life of
6 years.
Using the current stock price of \$26.91, an estimated standard
deviation of 40, a dividend yield of 1.21%. a riskfree rate of 4% and
the Black-Scholes option pricing model we arrived at a value of
\$2,129 million.
Since options expenses are tax-deductible, we used the tax rate of
37.30% to estimate the value of the employee options:
Value of employee options = 2129 (1- .373) = \$1334.67 million
87
Disney: Value of Equity per Share



Subtracting out the market value of debt (including operating leases) of
\$14,668.22 million and the value of the equity options (estimated to be
worth \$1,334.67 million in illustration 12.10) yields the value of the
common stock:
Value of equity in common stock = Value of firm – Debt – Equity
Options = \$38,804.48 - \$14,668.22 - \$1334.67 = \$ 22,801.59
Dividing by the number of shares outstanding (2047.60 million), we
arrive at a value per share o \$11.14, well below the market price of \$
26.91 at the time of this valuation.
88
Disney: Valuation
Current Cashflow to Firm
EBIT(1-t) :
1,759
- Nt CpX
481
- Chg WC
454
= FCFF
\$ 824
Reinvestment Rate=(481+454)/1759
= 53.18%
Return on Capital
12%
Reinvestment Rate
53.18%%
Stable Growth
g = 4%; Beta = 1.00;
Cost of capital = 7.16%
ROC= 10%
Reinvestment Rate=g/ROC
=4/ 10= 40%
Expected Growth
in EBIT (1-t)
.5318*.12=.0638
6.38 %
Terminal Value10= 1,904/(.0716-.04) = 60,219
Op. Assets
+ Cash:
+Other Inv
- Debt
=Equity
- Options
=Equity CS
Value/Sh
35,373
3,432
14,668
24,136
1,335
22,802
\$11.14
Cashflows
EBIT (1-t)
- Reinves tment
FCFF
\$1,990
\$1,058
\$932
\$2,117
\$1,126
\$991
\$2,252
\$1,198
\$1,055
\$2,396
\$1,274
\$1,122
\$2,538
\$1,283
\$1,255
\$2,675
\$1,282
\$1,394
\$2,808
\$1,271
\$1,537
\$2,934
\$1,251
\$1,683
\$3,051
\$1,220
\$1,831
Term Yr
3089
- 864
= 2225
Discount at Cost of Capital (WACC) = 10.00% (.79) + 3.29% (0.21) = 8.59
In transition phase,
debt ratio increases to 30% and cost
of capital decreases to 7.16%
Cost of Equity
10%
Riskfree Rate :
Riskfree Rate= 4%
\$1,871
\$995
\$876
Growth drops to 4%
Cost of Debt
(4.00%+1.25%)(1-.373)
= 3.29%
Weights
E = 79% D = 21%
\$ 26 at the time of this
valuation.
+
Beta
1.2456
Unlevered Beta for
Sectors: 1.0674
X
Mature market
4%
Firm’s D/E
Ratio: 24.77%
89
90
91
Relative Valuation

In relative valuation, the value of an asset is derived from the pricing
of 'comparable' assets, standardized using a common variable such as
earnings, cashflows, book value or revenues. Examples include -• Price/Earnings (P/E) ratios

and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples)
• Price/Book (P/BV) ratios

and variants (Tobin's Q)
• Price/Sales ratios
92
Multiples and Fundamenals


P0 
DPS1
r  gn
Gordon Growth Model:
Dividing both sides by the earnings,
P0
Payout Ratio * (1  g n )
 PE =
EPS0
r-gn

Dividing both sides by the book value of equity,
P0
ROE * Payout Ratio * (1  g n )
 PBV =
BV 0
r-g
n

If the return on equity is written in terms of the retention ratio and the
expected growth rate
P
ROE - g
0
BV 0

 PBV =
n
r-gn
Dividing by the Sales per share,
P0
Profit Margin * Payout Ratio * (1  g n )
 PS =
Sales 0
r-gn
93
Disney: Relative Valuation
Company Name
Point 360
Fox Entmt Group Inc
Belo Corp. 'A'
Hearst-Argyle Television Inc
Journal Communications Inc.
Saga Commu nic. 'A'
Viacom Inc. 'B'
Pixar
Disney (Walt)
Westwood One
World Wre stling Ent.
Entercom Comm . Corp
Liberty Corp.
Ball antyne of Omah a Inc
Regent Communications Inc
Emmi s Commu nications
Cumulus Media Inc
Univision Communic.
Salem Communications Corp
Average for sector
Ticker
Symbol
PTSX
FOX
BLC
HTV
JRN
SGA
VIA/B
PIXR
DIS
WON
WWE
CXR
BBGI
ETM
LC
BTNE
RGCI
EMMS
CMLS
UVN
SALM
PE
10.62
22.03
25.65
26.72
27.94
28.42
29.38
29.80
29.87
32.59
33.52
33.76
34.06
36.11
37.54
55.17
57.84
74.89
94.35
122.76
145.67
47.08
Expected
Growth Rate
5.00%
14.46%
16.00%
12.90%
10.00%
19.00%
13.50%
16.50%
12.00%
19.50%
20.00%
18.70%
15.23%
15.43%
19.50%
17.10%
22.67%
16.50%
23.30%
24.50%
28.75%
17.17%
PEG
2.12
1.52
1.60
2.07
2.79
1.50
2.18
1.81
2.49
1.67
1.68
1.81
2.24
2.34
1.92
3.23
2.55
4.54
4.05
5.01
5.07
2.74
94
Is Disney fairly valued?











Based upon the PE ratio, is Disney under, over or correctly valued?
Under Valued
Over Valued
Correctly Valued
Based upon the PEG ratio, is Disney under valued?
Under Valued
Over Valued
Correctly Valued
Will this valuation give you a higher or lower valuation than the
discounted cashflow valuation?
Higher
Lower
95
Relative Valuation Assumptions







Assume that you are reading an equity research report where a buy
recommendation for a company is being based upon the fact that its PE
ratio is lower than the average for the industry. Implicitly, what is the
underlying assumption or assumptions being made by this analyst?
The sector itself is, on average, fairly priced
The earnings of the firms in the group are being measured consistently
The firms in the group are all of equivalent risk
The firms in the group are all at the same stage in the growth cycle
The firms in the group are of equivalent risk and have similar cash
flow patterns
All of the above
96
First Principles

Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
– The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money (debt)
– Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.


Choose a financing mix that minimizes the hurdle rate and matches the
assets being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
– The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
Objective: Maximize the Value of the Firm
97
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